Are we Heading For a Recession?

Every time the equity markets go through a correction the recession chatter seems to pick up.  In the last few days, the chart below has started to pop up around the internet in support of the idea that we might be heading for one again.  It's a recession probability index (which isn't widely followed to my knowledge) but has a good track record of predicting previous recessions and is past the threshold that has signaled false alarms before.

The indicator was developed by two professors, Marcelle Chauvet and Jeremy Piger.  The inputs are: "a dynamic-factor markov-switching model applied to four monthly coincident variables: non-farm payroll employment, the index of industrial production, real personal income excluding transfer payments, and real manufacturing and trade sales."

I'm not particularly familiar with this indicator so it's tough to know what the biases could be, but I generally tend to be somewhat skeptical of models like this one.

A more time tested recession indicator is the slope of the yield curve--when the spread between 2 year and 10 year treasuries is inverted recession normally follows.  In a zero interest rate environment the yield curve may have lost some of its informational content, but it's been a great cyclical indicator for a long time and it's grounded in sound economic logic, so it shouldn't be totally ignored.  Today, even though the curve has flattened since '09 it is still not at or near the zero threshold.  As of right now I'm still on the lookout for the yield curve to go completely flat or invert when recession is imminent, even in this environment.

To clarify, I did write yesterday in my investor letter that I think recession will happen sometime in the next presidential term, but that doesn't necessarily mean it's imminent.  My base case is that it could start sometime late next year absent a totally botched fiscal cliff.  The forecast is mostly reliant on the average duration of economic expansions.  As I've written before, this expansion would be short even compared to the 1933 expansion if it ended today.

2s 10s spread

The Fed is set to speak again today and chatter of new stimulus has been picking up in recent weeks.  While it's been over a year since our last round of pure QE ended, we have been living in an operation twist world since last September, and can expect to continue to live in one through the end of the year at least.

While the effectiveness of twist on the economy is debatable, it's clear that the program has had a real effect on the steepness of the yield curve.  After reaching an all time steep level mid last year, the spread of the 10 yr vs. the 2 yr has been collapsing since.  In a typical economic cycle, recession would be about a year out now, and typically that would be accompanied by an inverted yield curve.  

Currently we are about one year into a flattening curve and if the pace continues we could be inverted by this time next year.  The question is, if 2 yrs are anchored at 0.25%, does that mean that the 10 yr could get that low?

How Does Housing Compare to the Tech Cycle?

Even though Bank of America is trading lower, today's quarterly release capped off what was a surprisingly good quarter for major US Banks.  In general, loans and deposits both showed growth, capital levels are extremely high and credit quality is significantly improved from where it was during the crisis.  Similarly, the housing sector has had some healthy reports as well recently (see previous post).

Seeing as how housing and banking were at the epicenter of the previous crisis, what does the fact that the two sectors are recovering say about where we are in the current economic cycle?  To try to help discern how this cycle compares to previous cycles, below is a chart comparing the performance of housing (ITB) and Financials (XLF) in this cycle to Technology (XLK) in the last one.  The chart shows relative performance of ITB, XLF and XLK compared to the S&P 500.  ITB and XLF are shown from 2006 and 2012 and XLK is shown between 2000 and 2007.

After the sharp collapse of technology stocks relative to the S&P from 2000-2002, XLK languished on a relative basis for the next four years before finally starting to outperform in 2006.  Similarly, both XLF and ITB showed steep drops and have continued to be losers since.  Now, years later, they may finally be starting to show signs of a turn.  XLK continued to steadily outperform the S&P 500 through 2012.  However, by the time XLK turned in 2006, the general economy only had one year left before it began to contract.